Do you have unearned income to claim on your taxes? Unearned income comes from passive sources but is often still subject to taxation. Some examples include pension income, capital gains, alimony, bond interest, gambling winnings, and so on. Annuity payments, interest income, distribution from retirement accounts, and rental income are also considered unearned income.
On the other hand, earned income is all the money you receive from working. This includes wages, salaries, tips, and all your earnings if you’re self-employed. Union strike benefits, plus some forms of long-term disability benefits, also fall under earned income.
You may be wondering how the IRS taxes unearned and earned income. If you guessed that they receive different tax treatments, you’re right. It’s important to understand how the two differ from each other so that you don’t make any mistakes when filing your taxes.
Taxes on Earned Income
If you’re an employee, you know that you don’t get to take home the full amount of your salary. Taxes are taken out of your paycheck, including Social Security, Medicare, federal and state income taxes.
You also have to pay these taxes even if you’re your own boss. For Social Security, you pay the full 12.4% of earned income and 2.9% for Medicare tax. If you’re an employee, you pay half of these taxes, and your employer pays the other half.
Taxes on Unearned Income
The good news is, payroll taxes don’t apply to passive sources of income (AKA unearned). But you need to specify them when you’re filling out your 1040 tax form for federal income tax purposes. They will be used to calculate your AGI or Adjusted Gross Income.
Now, here’s the tricky part. All the examples we mentioned earlier don’t have the same tax rates. Capital gains, for example, are taxed at a lower rate. The same also applies to qualified dividends.
Interest income, IRA withdrawals, and pension payments, on the other hand, are taxed at your marginal tax rate.
Your Key Takeaways
Passive sources of income help a lot once you retire and are no longer working. Plus, all the money you earned from these sources is exempt from payroll taxes. That’s why it’s advisable to save a lot early in life and build up your sources of unearned income.
It’s also important to understand that IRA contributions are dependent on earned income. If you don’t work for a year because you’ve won enough money through gambling or because you’re subsisting on unemployment benefits, you won’t have any contribution to your IRA for that particular year.
If you have retired or have decided to become self-employed, knowing all of this will help you prepare for dealing with a variety of tax rates. This way, there won’t be any nasty surprises such as finding out you owe the IRS money.
Take Control of Your Taxes
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